Operating lease accounting example

NOTE: Operating lease accounting will likely be changing (and may even be eliminated) as part of the FASB's pending revision of FAS-13.

Let's take as an example an office lease, for a portion of an office building. It lasts for ten years. The first 5 years, the rent is $5,000 per month; the second five years, the rent increases to $6,000 per month. There is also a clause to pass through any increase in property taxes that may occur.

In many cases, the "fair value" of a portion of a building is not easily determinable. If this is true, FAS-13 allows you to skip the present value test [FAS-13, para. 28]. Such leases will, as a rule, never convey ownership, so the only test left to determine whether the lease is capital is whether the lease term is 75% or more of the economic life. A building is typically assigned a life of 20 years or more, so this lease's 10=year term is considerably less than 75%, and the lease is considered operating.

If there were no change in the rents, the rental payments would simply be expensed as incurred, making very simple accounting (though the future rent commitment of all leases needs to be disclosed). Since this lease has a scheduled rent increase, which does not reflect a change in the availability of the asset (for example, an increase in the space covered by the lease), the rent is recognized on a straight-line basis over the life of the lease, with a deferred liability that accounts for the difference between cash rent paid and accrued rent expense.

Monthly journal entry (first 5 years)

Operating rent expense	5500.00
Deferred liability		500.00
Cash		5000.00

Monthly journal entry (second 5 years)

Operating rent expense	5500.00
Deferred liability	500.00
Cash		6000.00

At the end of the life of the lease, the deferred liability will be zero. If a lease is terminated early, you will recognize a gain equal to the balance in the deferred liability account.

In some cases, governmental entities need not level the rent as shown above. Under Governmental Accounting Standard #13 (GAS-13), rents may be expensed as incurred, even when they change during the life of the lease, "when the pattern of the payment requirements, including the increases, is systematic and rational." Increases in the rent due to actual or anticipated inflation are specifically listed as qualifying examples. In such cases, no deferred asset or liability is recognized; each month, operating rent expense is debited and cash is credited for the actual rent payment.

You also need to disclose your future rent commitments. At the end of the first year, for example, you have four years of $5000 per month rent remaining, plus five years of $6000 per month. (Future rent commitment disclosure is based on cash, not accrual, rent.) So as of the end of year 1, your disclosure would be:

The following is a schedule by years of minimum future rentals on noncancellable operating leases as of December 31, 20X8:

Year ending December 31,
20X9:	60,000
20X0:	60,000
20X1:	60,000
20X2:	60,000
20X3:	72,000
Later years:	288,000
Total minimum future payments required:	600,000

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Capital lease accounting is considerably more complex; see an example of that as well.